Amidst everything else happening, last autumn MHCLG released its SF3 data giving statistics on English and Welsh LGPS pension fund cashflow. I have written about this regularly, using data going back ten years. In 2011 there was a 0.8% (measured as a percentage of assets under management) surplus of contributions over expenditure and a further 1.9% of investment income. In 2020 (ie. data to 31st March 2020) there was a deficit of 1.2% of contributions over expenditure, a shortfall just about plugged by 1.6% of income. Net transfers into the Scheme amounted to an additional positive cashflow, so the overall surplus was 0.9%.
The SF3 data comes with all sorts of caveats: asset levels were particularly low in March 2020 and if calculated today the denominator would be 10% to 15% higher and the % numbers correspondingly lower; employer contributions in 2020 were artificially reduced by pre-payments made in 2018 to cover three years and we can expect the 2021 number to be higher in the same fashion; plus investment income does not catch all cash inflows.
The aggregate numbers in 2020 are quite similar to 2019, when the surplus including investment income was 0.3%. However, the downward trend since 2011 has not changed and on these measures we can expect the LGPS to show aggregate negative cashflow, even including stated investment income, within the next few years. 2021 income may well be boosted by pre-payments but income from real estate (0.2% of AUM in 2020) and equities (0.9%) will likely be reduced as a result of the COVID lockdowns.
There were 34 individual funds who had negative cashflow after including investment income in the year to 31st March 2020, compared to 38 in the previous year. If transfers in and out of funds are included, that number reduces to 18. Of these funds, nine are amongst the 15 most mature funds within the LGPS, with active members less than 29% of the total membership. These numbers are all similar to last year, but mature funds have less ability to increase contributions to plug the gap.
In our view all funds, and not just those facing negative cashflow, should be paying attention to cashflow planning. We would recommend two separate exercises: one looking at short-term flows over the next three to five years, where the numbers are more concrete but the need for assurance much greater. The purpose of this is to ensure that there is always sufficient money in the bank to pay pensions on time. The second is a longer-term plan over 20 years or so in order to identify gaps which may need to be filled; the data here on both asset and liability sides will inevitably be dependent on more or less heroic assumptions, but there is sufficient to paint the bigger picture.
Traditionally funds have used fixed income as a source of secure cashflow to match future pension payments, whether through LDI programmes or less formally. However, with even long dated gilts and investment grade yielding 1% to 2%, the opportunity cost of doing so is high and will often involve a larger or smaller element of converting capital into income. For example, the 4.25% 2049 gilt, with a nominal yield of 4.25%, is trading at 191. Investors receive a running yield of 2.2%, substantially higher than the redemption yield of 0.8% but will lose nearly half their capital over the next 28 years.
Funds are therefore having to look for other sources of income. Traditionally, the requirement has been secure income but in our view outside gilts that is a misnomer: if there is a higher yield, there is some additional risk in some form and it should not be called secure.
Reality is a spectrum of security, with investment grade debt broadly at the higher end, followed by infrastructure and real assets where long-term contracts are in place with secure counterparties, and then listed equities where - at least in aggregate - there is usually reasonable certainty, albeit with some economic exposure. The advent of revenue-related rental contracts in some segments of real estate makes their income profile closer to equities, with greater exposure to economic volatility than core infrastructure. At the lower end come areas such as non-investment grade or private debt and equity, where one or both of the level and timing of distributions is less certain.
Right now investment grade debt offers hardly any premium over government gilts, even at the lower end BBB credit ratings. It is no surprise that income-seeking investors are looking further out on this security spectrum and particularly at infrastructure. The risk they take here is that they end up over-paying for assets. Regular readers know that I have over time emphasised the fact that infrastructure can deliver an income stream, often strongly correlated with inflation, of 4% or 5% compared to index linked gilt real yields of -2%. However, there is a question of whether infrastructure spreads will also rise when bond yields do. We are watching their behaviour intently as the 10 year US Treasury yield rises over 1%. Investors may still be happy to obtain the running yield but may also suffer some capital loss, much as with the gilts example given above.
Private or non-investment grade credit is more about accepting credit risk to receive income, which investors are increasingly forced to do. Alternatives such as music rights or leasing assets mean greater complexity risk, especially the uncertainty of what happens at the end of their contracts.
There is no simple answer to how to fill the cashflow gap which is gradually opening up for LGPS funds and there are some easy ‘wins’ such as converting accumulation into income units. But, and our apologies for sounding like a broken record, the first step must be some detailed cashflow planning.